How CERC default feeds into broader EM concerns

China Energy Reserve and Chemical's bond default shows credit risk in China is rising and spilling over into international markets, so bond investors need to be increasingly selective.

Fears that more Chinese corporate borrowers are likely to default in the coming months and years have cranked up a notch after China Energy Reserve and Chemical (CERC) failed to repay its dollar bond, spreading some of the disquiet that has been rumbling onshore in China onto offshore markets.

The $350 million default, confirmed at the weekend, underscores Beijing’s determination to lance the boil of excessive debt within the country's financial system and shows the government should not be relied upon to bail out even those firms with deep ties to the state, investors told FinanceAsia.

CERC is controlled by the Beijing government and by cash-rich PetroChina, China’s largest oil and gas producer and the listed arm of state-owned China National Petroleum Corporation. It is engaged in oil and gas trading, logistics and distribution, according to its website, and counts other state-owned oil companies such as Sinopec and CNOCC, as well as PetroChina, among its key clients.

“The risk of default among Chinese borrowers is underappreciated,” a Hong Kong-based fund manager told FinanceAsia, declining to go on the record due to the sensitivity of the subject. “It is clear to me that the Chinese government is getting serious about systemic risk in the banking system, and the deleveraging campaign will eventually force more companies out of business.”

In a regulatory filing on Sunday CERC blamed serious liquidity problems for its failure to repay a $350 million bond that matured on May 11. The company said its inability to repay the 2018 bond was "due to the tightening in credit conditions in [China] over the last two years", which had restricted its access to financing channels including bank loans and onshore bond issues.
That said, it's not clear whether it had operational issues or had incurred financial losses due to the purchase of complex derivatives, according to some CERC bond investors, after the firm veered off from its core business into real estate investment. 
CERC grabbed the news headlines in November when it led a consortium to buy a 75% stake in The Center, Hong Kong’s most expensive commercial building, for the $5.2 billion, only to then sell a 55% stake in February this year.
Aside from its defaulted 2018 issue, CERC has another $1.8 billion-worth of outstanding dollar bonds maturing in 2019, 2021, and 2022. The 2021 bond was trading at 35 cents on the dollar on Wednesday.
CERC is not the first Chinese bond issuer to hit a wall of late. At least 11 other Chinese companies have defaulted on their onshore bonds so far this year as domestic credit conditions have tightened, including China CEF, a finance-to-energy conglomerate and Fuguiniao, a Hong Kong-listed clothing company, according to Wind, a data provider.
But CERC's default has helped to spread some of the disquiet that had been rumbling onshore in China onto offshore bond markets at a time when rising US interest rates, revived dollar strength, and broader trade concerns are already gnawing away at emerging market investor confidence.
"As the risk of default is rising in emerging Asia, the sentiment among emerging market investors has turned to be more cautious in 2018," the fund manager said.

Defaults in China have partly contributed to the relatively tepid tone of China's offshore bond market, with new issuance levels down on last year. Based on data collated by Dealogic, Chinese borrowers have only sold $30 billion of international bonds so far this year, compared with $37 billion for the same period a year ago.

They have also contributed to a widening in spreads between US government bonds and high-yield notes and are driving investors to conduct more strenuous levels of due diligence.

"Relative to the recent benign default history pertaining to Asian and Chinese credits, we expect the pace of defaults to rise going forward, which warrants rigorous fundamental analysis and careful security selection process," Karan Talwar, an emerging markets investment specialist at BNP Paribas Asset Management, told FinanceAsia.

"In the past few years, Chinese and Asian investors have been major buyers of Chinese US dollar-denominated debt, as they think they have better access to the issuer and understanding of the industry, but I think it is no longer sufficient to just rely on implicit government support -- credit fundamentals will matter much more going forward," he said. "As China’s deleveraging campaign gathers force, you should expect to see higher default rates in both the onshore and offshore market."

CERC said it planned to offload certain assets to ease the cash crunch, without providing further details on how much it plans to raise.

As a result of the missed payment, the company automatically defaulted on its 2021 and 2022 bonds too. It will stop paying interest on the two bonds and begin restructuring talks with bondholders.

“We’ve seen some private banking investors and fund managers punting the [2021] bonds at 30 cents,” a bond trader told FinanceAsia late Tuesday, after seeing the bonds fall by 45 points in two days.

That left them below another distressed name currently in the market -- Hong Kong house builder Hsin Chong, the trader said.

Hsin Chong said it had failed to redeem its $300 million 8.75% senior bond maturing on May 18. The missed payment also triggered a default of its $150 million 8.5% bond due in 2019.

Hsin Chong said it was in discussions with two other property companies, Poly Property and Kaisa, about a potential lifeline.

“We expect to see more credit spread differentials both for investment-grade but more so for high-yield credits, and the pace of spread increase for high-yield bonds should be faster than investment-grade due to higher default and liquidity risk,” Talwar said.

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